5.4 Business Valuation - Discounts
and Premia

Just because a business
has ascertainable value -- because of a predictable
earnings stream or marketable assets -- does not mean
that the value of investmentinterests
in the business are immediately ascertainable. It is
one thing to say that Widget Inc. will generate $100,000
in annual earnings over the next 10 years and quite
another that a 1% shareholder of Widget has an interest
that is worth $1,000 paid annually for 10 years.

In this section, we first look at the bundle of rights
that inhere in ownership interests - particularly common
stock in a corporation. We then turn to the deviations
from pro rata valuation when an owner has either a controlling
interest (control premia) or a non-controlling minority
interest (minority discounts). Finally, we consider
the effect of illiquidity in valuing an ownership interest
(marketability discounts). In many valuations, discounts
are the essence of the game.

Business ownership interests carry certain essential
rights. The owner has financial rights to a portion
of the firm's income stream, governance rights to participate
in choosing managers and making business decisions,
and liquidity rights to sell or dispose of these rights
to others. (More 5.4.1>>)

When a purchaser acquires a 100% interest of a business,
included is complete control. The purchase price includes
a "control premium". Data suggests that shares
with control comand a premium of 30-40% above the value
of freely-traded non-control minority interests. (More
5.4.2>>)

Financial interests owned by persons lacking control
(minority interests) are typically worth significantly
less than the pro-rata share of total firm value. In
a corporation, noncontrolling shareholders cannot compel
the declaration of dividends, the payment of salaries,
the carrying out of business plans, or fundamental transactions
such as a merger, sale or liquidation of the company.
How much should minority shares be discounted? (More
5.4.3>>)

The inability to readily sell a financial interest
(whether because of a lack of willing buyers or contractual
restrictions) significantly reduces its value. After
all, what's so great about the promise of future returns
if you need money now? (More 5.4.4>>)